02/2018 Market Commentary

Market Risk and Volatility

The life insurance industry is being blamed for the market volatility experienced in February due to their volatility-controlled products. Much of this rests on variable annuities, which experienced trouble during the financial crisis. Since then, life insurance companies have acted to “de-risk” products so as to minimize their balance sheet risks. But risk is only transferred and/or not correctly evaluated (bottled up even). Sure, volatility-controlled products and practices erupted in February, but it is hard to blame what happened on the life insurance companies alone. They exasperated the results, but they did not cause them. It is akin to blaming sellers for lower prices  (it is a required condition of lower prices but not a fundamental cause). The cause, as we will find out, is that market values are high, and investors became fickle.

Insurance and Reinsurance

Two large insurance and reinsurance groups have received takeover interest. Swiss Re has been approached by a large Japan-based investment vehicle about a substantial minority investment. On the other hand, XL Group has received strong interest of possible acquisition from Allianz. Much of recent mergers and acquisitions were between small and mid-sized insurers and reinsurers. Swiss Re and XL Group are mid- to large-sized. Such continued acquisition interest underscores the amount of capital that remains committed to the sector. As previously noted, Ballast does not believe broad insurance market hardening will occur until capital is flushed. This can come in two forms (1) capital market losses (investments on balance sheet) and (2) insured losses. More than likely, this insurance market will require both, but we remain tuned in as opportunities are likely to arise along the way.

General Electric

We wrote about GE previously, and February proved to be another interesting chapter for the company. The SEC announced that an investigation, management cut forecasts on accounting changes, and a major board shake-up are all in the works.

 

We read a hedge fund piece suggesting that a fundamental business shift would be triggered by a credit ratings downgrade. GE sells long-term service contracts on its industrial products. Purchasers are sensitive to long-term credit ratings because they want the counter party to be around in X number of years to perform on the contract. The hedge fund suggested that a downgrade would be catalyzed by recent deterioration at GE, and sales would suffer following downgrade, creating an air pocket. The implication was that GE now needs to raise equity capital (something GE does not want to do) to prevent a rating downgrade. The case presented was interesting, but we disagreed. To better understand, we contacted the hedge fund and investor relations of GE. Neither have responded yet but we continue to follow GE with interest.

China / Anbang

Many are not likely to recognize the name Anbang, but it is one of the largest finance and insurance groups in China. It was fast growing thanks to the help of Wealth Management Products, a risky financial product used across the country to finance China’s rapid growth. During February, Anbang was taken over by China’s insurance regulator because of market risks it posed on the economy. Observers called it too big to fail. Either way, we see this as an important moment. As one of the largest insurers in China (and certainly not the only one to extensively use the risky products) we think China is crossing over into challenging waters as they attempt to wring out the market excesses while maintaining stability. We are not convinced that an insolvent market as big as this one can be made solvent without reverberations elsewhere.

Walmart

Another month, another takedown by Amazon. Walmart reported disappointing online performance, and the stock price reacted by falling 10% in a day, which is a very large move for a company as big and stable as Walmart. This caught our attention, but like our commentary on the broad market pullback, Walmart’s price drop was hardly meaningful. It reversed price gains back to November 2017 levels, at which time the stock price jumped 11% on encouraging online sales. The market giveth and the market taketh away… We are still interested in Walmart so long as the price continues to decline and the dividend yield becomes more attractive.

Inflation & Interest Rates

Popular narrative right now is for rising inflation and, as a result, much higher yields. We disagree with the former and doubt the latter.

 

First, inflation. Inflation has fallen and barely budged since the financial crisis despite herculean efforts of central banks. The only major inflation evident was through asset prices but not very much through consumer or producer prices. The collapse of commodity prices was no help, nor has it created deflation. So, now that the commodity complex appears to have been stabilized, fears have renewed at the (slightest) advance in inflation metrics that inflation will take hold, and interest rates will have to rise dramatically. For a variety of reasons, we think this line of thought is unfounded, and such commentary is inconsistent.

 

Then, rates. The Federal Reserve appears to be determined to raise rates at the front-end of the curve (includes overnight loans or t-bills) and will no doubt accomplish this. The Federal Reserve will get much help from the Treasury, which now must issue a lot of debt in coming years to fund the US Government’s deficit – expected to be close to $1 trillion (that’s a ‘T’) in 2018. The Treasury has indicated much of this funding will be done with short-term debt. But the long-end of the curve (includes 10- and 30-year bonds) are less likely to move substantially higher. (They could, but we are skeptical.) The major bond market participants in the long-end of the curve are pensions, insurance companis, et al, and their business and underlying demographic situation is unlikely to change near-term – (That is, pensions still need to be invested with the long-term stability of fixed income and life insurance companies continue to grow retirement & income protection products that rely heavily on the security fixed income provides.) If it exists anywhere, the supply and demand imbalance in fixed income markets that could drive rates higher, in our opinion, rests on the front-end of the curve. This is not worrisome to us.

 

Despite our beliefs that rising inflation is not yet around the corner and that long-term rates are unlikely to rise substantially in the near-term, we are adding positions to portfolios that we think provide protection against either condition, while still rewarding the investor in the interim.

Teva

We have discussed Teva nearly every month of the newsletter. February should be not different. Two things occurred (1) Teva reported full-year 2017 financial results that showed revenues falling faster than many analysts expected and (2) Standard & Poors finally joined peers Moody’s and Fitch in junking the credit ratings. S&P downgraded the credit ratings two notches from BBB- to BB. The shift to “junk” ratings is important because it leads to greater constraints on raising capital, and Teva is highly leveraged.

 

One other noteworthy Teva event during February was that Berkshire Hathaway purchased a chunk of Teva’s stock. When Berkshire (as equity holder) is subordinate to Ballast (as bond holder) we feel even better about our thesis.

01/2018 Market Commentary

Teva

Moody’s downgraded a story we’ve covered in previous posts to below-investment-grade ratings, aka “junk” or “high yield”. This is the second such rating agency to downgrade Teva to junk. That means the bonds now officially transition to the high yield markets, typically making bond yields more attractive. This is the next leg of our thesis playing out. Remember, we think there is long-term value in a large generic pharmaceutical company like Teva.

Microchip Security Flaws (Intel)

Intel has a been a stock we’ve kept an eye on recently, as it is a high-quality company with industry leading technologies and a high probability of remaining a key force in the tech industry for years to come. To boot, Intel pays a dividend, which seems ever rare in this new technology growth wave.

 

In early January, a researcher discovered a major security flaw to chip architecture called ‘x86’. There were many manufacturers impacted, but none more so than Intel. The flaw impacts computers dating back to the mid-90s and the fix, if there is one, could dramatically slow computers – a costly proposition. Intel and the tech sector fell in price on the news. Ballast perked up even more on the pull-back of Intel’s price, but investors quickly brushed off the news, and the price ran away from sensible levels. It didn’t help us that Intel released strong, estimate-beating earnings figures that sent the stock rallying an additional 10% higher.

TV Programming (Netflix)

Netflix stock has been invincible and continues to defy traditional valuation methods. With no (to little) earnings and a massive negative cash flow, the stock price continues to rise. Market capitalization for Netflix increased by $10bn as the price jumped from $225 to $250 after the company announced 2 million new subscribers, which was higher than expected. As one commentator put it, and we paraphrase: “that is $5,000 per subscriber, or that $5,000 would hit the top line after just 35 years at today’s subscription pricing”. Let that settle in. That represents revenue [not income] over 35 years’ time. Are investors valuing this company correctly?

 

Here are a couple additional thoughts regarding Netflix. Between 2010 and 2016, original TV shows have more than doubled. Netflix original content is fifth most popular on its own platform behind CW (owned by CBS & Time Warner), Fox, Disney, and CBS. On its own platform! Each of those named leaders is already working on building their own platform or partnering to do so.

 

Our final thought regarding Netflix is from David Einhorn, a respected manager of hedge fund Greenlight Capital. We thought he framed it succinctly when he wrote in a recent letter to investors:

 

“[Time Warner] and Netflix now have roughly the same enterprise value, despite [Time Warner] having a better library, an exciting content creation engine and substantial current profitability.”

 

Time Warner owns Warner Brothers, HBO, TNT, TBS, CNN, Cartoon Network, etc. and an exhaustive list of accompanying TV and Movie content.

Tesla

Speaking of highly valued stocks defying traditional valuation methods, Tesla is now among the largest car manufacturers by market capitalization. However, they hold this ranking with no profit, with only a fraction of the vehicle production/sales, and with unproven ability to meet targets and scale production. We like a successful visionary and innovative company as much as the next person, but we offer caution against pricing for perfection. Are “investors” renting or owning this stock?

Insurance/Reinsurance

Last year was a bad loss-year for insurance and reinsurance companies. January 1st was a big day for the industry because much of the property catastrophe reinsurance business is (re)priced on that day each year. Pricing increases or decreases can give indication as to whether the insurance market is hardening (as with price increases) or softening (as with price decreases). Overall, the news delivered modest price increases, and so, we think the industry could be in for a status quo of a soft market. We continue to monitor.

General Electric

GE, as it is commonly known, has been in downsize mode ever since its financial unit nearly collapsed the company during the financial crisis. The company has shed countless assets in effort to reduce risk and boost stock price performance that has been anemic going back to the days of Jack Welch. GE was considered a model company under Jack Welch and his six-sigma regime. (GE was practically considered a management university.) However, this may have been a facade given the long poor share price performance. A recent announcement highlights that management may have been good at window dressing too. GE announced its reinsurance unit would take a $15 billion reserve charge and require statutory capital contributions. GE will accomplish this by suspending GE Capital’s dividend to the parent company, allowing for contributions to the financial unit. This was disappointing, but not very surprising given the poor financial health of Genworth, the life insurer that the GE unit reinsures. GE’s share price has suffered from this and other announcements, and management has reduced the dividend to shareholders. Investors have been fleeing, but Ballast sees opportunity. After all, GE remains a leading industrial group, manufacturing aircraft engines, locomotives, power generation turbines, healthcare equipment, and oil & gas equipment & services. We continue to monitor GE.

Howard Marks on Market Risks

There is much to be said about investing and risks, especially given the recent years’ runup in asset values. Rather than presenting more of our thoughts here this month, we offer a few quotes from a recent memo to investors by Howard Marks, a respected investor and founder of Oaktree Capital. (Bold type as presented by the author).

 

[Re: today’s market prices] Most valuation parameters are either the richest ever (Buffett ratio of stock market capitalization to GDP, price-to-sales ratio, the VIX, bond yields, private equity transaction multiples, real estate capitalization ratios) or among the highest in history (p/e ratios, Shiller cycle-adjusted p/e ratio).  In the past, levels like these were followed by downturns.  Thus, a decision to invest today has to rely on the belief that “it’s different this time.”

It appears many investment decisions are being made today on the basis of relative return, the unacceptability of the returns on cash and Treasurys, the belief that the overpriced market may have further to go, and FOMO [“fear of missing out”].  That is, they’re not being based on absolute returns or the fairness of price relative to intrinsic value.  Thus, as my colleague Julio Herrera said the other day, “valuation is a lost art; today it’s all about momentum.”

The potential catalysts for decline that we have to worry about most may be the unknown ones.  And although I read recently that bull markets don’t die of old age or collapse of their own weight, I think sometimes they do (a dollar for anyone who can identify the catalyst for the collapse of the bull market and tech bubble in 2000 – it’s not easy)

 

For one thing, I’m convinced the easy money has been made.  For example, the S&P 500 has roughly quadrupled, including income, from its low in 2009.  It was certainly easier for the p/e ratio to go from the low teens in 2011-12 to 25 today than it would be for it to double again from here.  Thus, the one thing we can say for sure is that the current prospects for making money in U.S. equities aren’t what they were half a dozen years ago.  And if that’s the case, isn’t it appropriate to take less risk in equities than one took six years ago?